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If a bank does not have enough own reserves, it can borrow excessive reserves from another bank as a temporary short-term loan. The federal funds rate is the price of this loan, represented by the short-term interest rate. However, in economics, all processes are interconnected, and such federal funds rates have an impact on other interest rates. Thus, an increase or decrease in this rate also affects the borrowing cost for businesses and households (Mankiw, 2020). If federal funds rates go down, then borrowing becomes cheaper, which results in buying more goods, and the business can hire more workers and buy equipment. This aspect has a direct positive impact on unemployment rates as there are more jobs. Accordingly, with an increase in federal funds rates, borrowing becomes more expensive, which reduces the purchase of goods and services, as well as the number of jobs.
It is also important that changes in federal funds rates impact the inflation rate due to the same processes. With a decrease in federal funds rates, as already noted, borrowing becomes cheaper. Accordingly, the dispute on goods and services increases because people begin to buy more in comparison with the past. Increased demand can accordingly create a certain shortage of goods and services, which leads to higher wages and other production costs. This process, in turn, affects inflation rates, significantly increasing them. The Federal Reserve may raise federal funds rates so that interest rates for businesses and households also rise. This action increases the cost of borrowing and reduces the demand for goods and services, which reduces inflation. Accordingly, if inflation is low, the Federal Reserve may lower the federal funds rate, reducing interest rates and stimulating economic and inflation growth.
Reference
Mankiw, G. N. (2020). Principles of economics (9th ed.). Cengage Learning.
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